Friday, August 22, 2008

Will it be this weekend?

The two state sponsored giants of the US mortgage industry are as close to the edge of the abyss as it is possible to be without actually falling in. Their share prices have crashed, and both have a massive funding gap to fill within the coming weeks. However, Freddie and Fannie won't be staring into that black hole of failure for very long. Something is going to happen, maybe as early as this weekend.

A strange mixture of knowledge and uncertainty is the key to understanding this mess. No one really knows how bad their balance sheets are, although everyone has a fair idea that both agencies are carrying a lot of dysfunctional debt. Everyone knows that the US government feels responsible for Freddie and Fannie, however, no one really knows how far this sense of obligation might go. In the event of failure, will the government cover the shareholders (almost certainly not), what about preferred equity (probably not), subordinated debt (maybe not), and so it goes on.

In such dubious circumstances, it is hardly surprising that Freddie and Fannie would have some difficulties raising cash, while shareholders desperately try to sell up and move on.

On executive at one of the firms, speaking anonymously, put it rather well. "We’re in a Catch 22. As long as there is uncertainty over Treasury’s plan, we can’t raise money, and as long as we can’t raise money, there’s going to be more and more speculation about Treasury’s plan."

Perhaps, the US Treasury might put a stop to this nonsense this weekend and explain exactly what they will and won't cover. One thing is for sure, things will never be the same in the US mortgage market. Those happy days when the government implicitly guaranteed private sector housing debt will soon be over. Freddie and Fannie will be restructured, run down and rolled away into the private sector, and as far away as possible from future government guarantees.

Bloomberg interviews Yu Yongding, a former adviser to China's central bank who said, "If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it is not the end of the world, it is the end of the current international financial system."